District 5 Diary

Sunday, August 14, 2011

Thomas Hoenig tried to warn us

Back in 1996, in a speech at the World Economic Forum in Davos, Switzerland, [retiring president of the Federal Reserve Bank of Kansas City] Thomas Hoenig warned about the dangers of expanding the federal safety net to cover financial institutions trading complex derivatives and structured finance vehicles:

“The threat of failure keeps a bank honest and inhibits it and the industry from trending toward excessive risks. Without this market discipline provided by creditors willing to withdraw their funds when they suspect a bank of being unsafe, banks have an incentive to take excessive risks.”

Mr. Hoenig’s prescription was to bar institutions that engage in risky business from offering government-backed deposits and to minimize their access to emergency Fed loans. Although he has been vindicated in this view, big bankers howled and regulators yawned at the time.

“I was trying to point out that these kinds of activities are beyond management’s control,” he recalled, “and that if you want to do this, you cannot have the taxpayers subsidizing it.” He added: “It was controversial. It was not well received by some.”

In 1999, as Congress was finally doing in the Glass-Steagall rules that had separated investment banking from old-fashioned commercial banking, Mr. Hoenig made another public warning about big, interconnected financial companies. “In a world dominated by megafinancial institutions, governments could be reluctant to close those that become troubled for fear of systemic effects on the financial system,” he told an audience at the European Banking and Financial Forum in Prague. “To the extent these institutions become ‘too big to fail,’ and where uninsured depositors and other creditors are protected by implicit government guarantees, the consequences can be quite serious.”

We sure found that out...

Another important theme for Mr. Hoenig concerns the mistrust that has arisen as regulators provide favors to powerful institutions while asking other industries, and ordinary Americans, to accept less. Ask farmers to accept fewer federal subsidies, or the housing industry to live without the mortgage tax deduction, or ordinary Americans to contemplate changes to Social Security, and they all push back, he says.

And many of these people say the same thing: “Why should I compromise when the largest institutions get bailed out and continue to get their bonuses?” he says...